Should make for very good reading material!

We have more comments, but rest assured that we will keep following his letters – perhaps one day we can write a post as flattering as the one we wrote about Warren Buffett’s letters…

Highlights (general):

In general terms, the breadth of subjects he wrote about is already worth praising. It seems like a good, albeit obviously not complete, set of subjects to discuss in order to put past and future performance into context.

Finally, having the divisional Heads write their own letters to investors (thankfully shorter) is a great idea, one that should probably be adopted elsewhere.

Highlights (specific):

“Our first priority was to restore a decent dividend – this is what our shareholders wanted (if it were up to me personally, I would reinvest all the capital into our company and not pay any dividend – but this is not what most shareholders want).”

“Five years ago, very few people seemed to worry about outsized risk, black swans and fat tails. Today, people see a black swan with a fat tail behind every rock.”

On the need for the US to address the challenges ahead of it (budget, entitlements, immigration, education etc.): “The sooner we address these issues, the better – America does not have a divine right to success, and it can’t rely on wishful thinking and its great heritage alone to get the country where it needs to go. But I remain, perhaps naively, optimistic. As Winston Churchill once said, ‘You can always count on Americans to do the right thing – after they’ve tried everything else.’ “

He makes a passionate defense about the value of his firm’s (and the global banking system’s) offerings to the global economy and ultimately all of its agents – when the banks do it right. He does it through a very personal story about a trip to Ghana with his daughter, which is a rare tale from a Fortune-500 CEO.

The part above is fodder for the next section, about new regulation and its impact in the financial system. That by itself is worth the download, despite the obvious “don’t ask the hairdresser if you need a haircut” cautionary note.

We expect to publish an update with further highlights.

We posted an interview with Mr. Klarman back in September, also worth the read.

A little less than two years ago, the consensus among market players was that there was “extremely low visibility” for the next few quarters and that “the occasion called for caution”. Considering that the world financial system was close to the abyss, it was indeed advisable to adopt a conservative attitude – though at times like those in 2008, to have high-quality real assets at very low prices seemed to us a more attractive alternative than lending money to governments. The “low visibility” issue, however, is a matter that deserves greater reflection.

Is it true that, over time, investors really alternate between times of “excellent visibility” and “very poor visibility”?  Or is it possible that this is an illusion of the human mind, and in reality investors alternate between times in which they think there is greater or lesser visibility? We believe that the second alternative is the one that best describes the real situation: the future is uncertain by nature and what varies is our perception of it. As Warren Buffett once said: “Forecasts usually tell us more of the forecaster than of the future”.

Many market players live under the illusion that the future is foreseeable, and using worksheets where projections cover from 5 to 10 years, they end up perpetuating situations and circumstantial results, ignoring the natural business cycles. This is one of the traits of the human cognitive system: the tendency to attach greater importance to recent events than to older ones. It is natural, therefore, that in a crisis environment, negative aspects prevail over positive ones, and that at good times the opposite occurs. Perhaps even more worrying is the fact that events with fat-tail[1] characteristics start being neglected in analyses. In another curious trait of our cognitive system, Daniel Kahneman, who won the Nobel Prize for Economics in 2002, calls attention to the difference in individuals’ perception of gains and losses. An individual who loses R$50,000 tends to feel a negative impact greater than the positive impact of a R$50,000 gain.

All these aspects help to explain why the markets are doomed to alternate times of under-valuation and over-valuation. When the economic environment deteriorates, there is a general perception that “visibility” is lower, so that analysts and investors not only revise their projections downward (perpetuating low returns and results), but also their portfolios, usually in order to bring painful financial losses to a halt. During the process, prices start to better reflect the uncertainty of the future. When the economic environment improves and remains positive long enough, the opposite occurs and the visibility illusion appears again. All goes well until a new and “unexpected” adverse event occurs, and the cycle starts again. History shows us that turbulence and adverse events occur more frequently than investors would like: something always happens! That is why discipline and patience are necessary.

Just to illustrate some of the problems that are prowling around us at present: growing domestic inflation and interest rates in a rising trend; slack domestic fiscal policy, including the dangerous use of state-owned banks; default on the debt of several countries in the Euro zone; the sustainability of the Euro as a single currency; the possible mass adoption of mercantilistic policies (which lead to competing devaluations among the main currencies, rising protectionism and reduced world trade); rises in taxes worldwide; the “unexpected” rise in US debt (due to aid for bankrupt states); the Chinese growth model giving signs of  exhaustion; the ageing of the Japanese population and its impacts (difficulty in refinancing Japanese government securities); etc… As Ronald Reagan would say, “Government is not the solution to our problem, government is our problem”.

In the month of May, 431,000 new jobs were generated in the USA, of which 411,000 resulted from government hiring of temporary workers for the 2010 US census. How long will the government manage to support the US economy?

The thing is that, at present, there are a great number of possible adverse events that may trigger a reduction in “visibility” and in the appetite for risk worldwide. And when we look at the Brazilian market, we continue getting the impression that a great many asset prices already reflect optimistic expectations and there is little room for surprises. As Nassim Taleb said: “Beware of calm waters”… In this context, we continue waiting for clearer opportunities where we may allocate more funds safely, and meanwhile we receive over 10% per year in interest for being patient – which is not bad at all.

Where may we be wrong? One possibility, for example, is that Brazilian assets in general might accompany a possible appreciation in the US stock market, which in turn would occur only to offset the continuous issuing and loss of value of the US currency, and the loss of control over US inflation. Thus, the nominal appreciation of assets would only serve to keep the value of companies constant in real terms. We do not believe there is any justification for the Brazilian market as a whole to accompany this appreciation, unless Brazilian domestic inflation also gets out of control. And even if this happened, the risk/return ratio would not be worthwhile. According to Warren Buffett’s teaching in his fantastic article of 1977, “How Inflation Swindles the Equity Investor”, at times of high inflation, investment in equities is only the least mediocre alternative among many others. The perverse effects of inflation also impact companies’ results and investors’ gains. When adjusted for inflation, the gains, in real terms, tend to be very poor.

Q1 2010 report excerpts

The last few months were a period of much study and few operations. Following a time with plenty of clear opportunities, since the last quarter of 2009 we have found ourselves in a phase with few new situations in which we could have great convictions.

During the first quarter of 2010, we took part in six conferences in Brazil and the USA, including some focusing directly on investors and some to do with companies themselves and sector professionals. There were over 200 presentations and there were advances both in getting to know companies and sectors better and in identifying potential new opportunities. In the short term, however, we did not find any that would fit the “easy as falling off a log” category (high value and low price) that we like so much. As the historic Peter Sellers character would say in the fantastic film “Being There”, “there’s a time for planting and a time for reaping”.

We take the opportunity to thank readers for their participation and suggestions in the Buysiders.com website, IP’s blog. We have recently started using Investidor    Profissional’s    pages    in    Facebook and in Twitter to publicize the new articles released in Buysiders.com. This is still an embryonic use of these tools, but it may make things easier for those who are already well acquainted with them.

PROSPECTS: Brazil

Lately, in addition to all the efforts applied to studying specific companies and sectors, we have allocated more than the habitual amount of time we dedicate to macro and political questions. In fact, we have “worked” more than ever and studied much more than the historical average. Mainly thanks to the maturity reached by the IP model, we have spent less time on commercial and managerial issues.

It is important to make it clear that we have not changed at all our fundamental belief in the way we should operate. Much to the contrary. But we always seek to take care not to allow the “execution mode” to prevent the basic assumptions from being revalidated from time to time. And recent times have clearly called for a revalidation. What is the risk of a swerve towards a more populist agenda, where property rights are less respected? After all, we have lived with movements like the “landless people’s movement”, and with growing rumors of coercion against certain companies and entrepreneurs, as well as restrictions to the press and controversial constitutional amendments proposed by the government. We have the example of “Chavismo”, which has not been repelled by the Brazilian government, indicating a lower degree of aversion than we would like to a regime that is so primitive and harmful to society.

What are the risks involved in the renewal of concessions, or in the creation of new and yet heavier taxes, rates and “contributions”?

Our conclusion up to now? If we have not reached (and are not even close to) an “all in” position, like the famous Warren Buffett declaration regarding the US economy (…) we are moderately optimistic regarding the Brazilian economy in the medium term. By fits and starts, the institutionalization of Brazilian politics is taking place. Even the worst elements are not succeeding in perpetrating greater and more lasting damage to the extent of annulling the advances achieved in the last 16 years (…). Our fears of a greater and longer negative discontinuity in the fundamentals are relatively low.

President Lula is an example of the fact that, with a certain degree of common sense, even historical opponents of a liberal capitalist society end up surrendering to most of the evidence contrary to their ideological beliefs. The government’s efforts to continue the initiatives of the previous Administration in order to make the real-estate market viable are another example. This is a sector that keeps the economy spinning, but one which did not have “wealthy sponsors” (…). Fortunately, the logical thing happened and things are moving.

In economic terms, in addition to the (already commonplace) commodities, the domestic market development case becomes better consolidated day by day, based – by order of solidity and importance – on the demographic profile, the formalization of the economy, credit expansion, and a not-so-bad political scenario.

Companies and their businesses do not exist in the void, and whenever we identify “clouds of change” on the horizon, we pay much greater attention. So far, so good…

So we should explain why we do not “fill up the bucket” in view of such good fundamentals for the Brazilian economy, and manageable disturbances. As always, we have to weigh up the asset price factor. The present levels, in general, already take into account a large portion of the prospects listed. Turbulence does happen, and when it does, many people panic. The best moments to fill the bucket are these: good fundamentals plus panic caused by the situation of the moment. Until then, we maintain our positions in companies that not only have fundamentals that lead them to consistently surpass market expectations, but also have a good cash reserve.

PROSPECTS: Global

We remain quite cautious. The improvement observed in the symptoms are a result of the “liquidity flooding” measures taken since the 2nd half of 2008 – and not of a frontal attack on the fundamental causes that weakened the markets. Populist policies in the main economies continue to set the tone of governments. They all seek an exchange-rate depreciation as a way to improve their trade balances and boost their economies. Obviously, in a scenario like this, this brings us to a race towards the bottom.

Economics is far from being an exact science. The FED, still the great protagonist of the world economy, seeks a narrow path between the precipice of depression and the “dragon” of inflation. In difficult situations like this, the stronger aversion tends to prevail. “Helicopter” Ben was given this nickname because of his thesis in relation to Depression, where he concluded that the solution was to “print” money until the economic agents lost their fear and returned to economic activity. It makes sense, but the risk is obvious. A loose monetary policy brings inflation, with a few years’ lag. The most likely scenario at the moment is that of constant growth in the inflationary risk in the USA, borne by many people who focus on the American Government’s gains arising from the depreciation of its debt – largely fixed-rate, in Dollars. In a scenario like this, the majority lose. Or rather, feel in their pockets the costs of the party, the incompetence, hypocrisy, and irresponsibility of the past. Those with greater power to adjust prices and hold long-term fixed-rate liabilities gain – or suffer less. (…)

An interesting exercise is to try building a counter- case. What could go so right as to neutralize the clouds on the horizon? We imagine events that would radically alter our general perception:

1. Reduction in conflicts based on religious extremism.

2. Radical productivity gain in the healthcare sector – which every day consumes an ever greater part of societies’ resources – in line with what happened to the production of clothes and food.

3. A pick-up in the speed at which knowledge and education are disseminated. This is where we see the strongest driver and the one most often present, which has made itself keenly felt in the last two decades with the advances in telecommunications in general, and the Internet in particular.

4. Improved public governance systems. The predominant government models today seem to us clearly deficient and a much greater threat to the well-being of mankind than the famous global warming, for example (which, if true, reflects a flaw in public governance itself). A reduction in the general hypocrisy is the greatest target to be pursued and the event that would bring the greatest gains to mankind.

Unfortunately, for certain problems, the speed of progress seems to be lower than what is needed to avoid more acute crises, which are historical catalysts for many necessary changes.

Obviously, the short list above says much more about our lack of capacity than about the real probabilities of results. One of the determining factors for advances in History lies in the fact that some societies and civilizations sometimes change on account of a single individual. But, for each case like the US rally of the eighties and nineties, there is a USSR, just to mention the biggest and most recent examples. After all, “lost civilizations” is a very commonplace expression (about 494,000 quotations in Google in 0.28 seconds…).

“Let’s hope for the best but prepare for the worst…”

Last but not least, for those interested in an inside view of the crisis, in the value of an independent view and in yet another report on the general institutional blindness (to say the least), we strongly recommend the videos and articles written by Michael Lewis when publicizing his book “The Big Short” (which we also emphatically recommend). The links to the relevant videos and articles can be found on Buysiders.com.

FOOD FOR THOUGHT

The Italian political scientist Antonio Gramsci was, as is well known, a great thinker. Gramsci’s Marxist convictions do not invalidate many of his ideas and observations. One of his lucubrations is about the significance of the dominant power exercised through ideology and culture, where the values of the bourgeoisie become the “consensus”. Everyone then identifies with this consensus, helping to maintain the status quo. Although Gramsci was obviously referring to the class struggle between the proletariat and the bourgeoisie, one wonders whether this has not been replaced by (or at least is not comparable to) the present situation between the big shots of corporate America (including, of course, the big banks) and the “rest”, here including most investors? Or people in government versus those they govern, in general?

MISCELLANEOUS

“The problem with socialism is that eventually you run out of other people’s money.” – Margaret Thatcher

“Only the paranoid survive” – Andy Grove

“If you want to know where the next crisis will be, then look at where the leverage is being created today. And nowhere is there more leverage being created at the moment than on sovereign balance sheets. What is happening is an experiment never undertaken before.” – Martin Barnes

“The best way to think about investments is to be in a room with no one else and just think (…) What you are looking for is some way to get one good idea a year. (…) Wall Street makes it money on activity. You make your money on inactivity” – Warren Buffett

Seth Klarman

We highlight below a few quotes from the always interesting annual report by Seth Klarman about what lessons investors should have learnt from the 2008 crisis, with which we agree 100%:

• “Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return.”
• “Risk is not inherent in an investment…Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.”
• “Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.”
• “A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.”
• “Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.”
• “Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.”
• “To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.”

The numbers that matter: US$ 131Bi in equity, US$ 62Bi in float => ~ US$ 193Bi in “capital”. Book value grew 20%. Float grew 5.8% (from US$ 58.5 to US$ 62Bi). All insurance businesses operated with underwriting profit again. Cash = US$ 30Bi (US$8Bi used in Q1 to pay part of the BNSF deal). Operational assets = US$ 30Bi but generated only US$ 1.1Bi in net profits, which shows insurance/investments did the heavy lifting. The operating units will hopefully make up their fair share of contribution in a recovery.

Bottom line: investors are still paying about capital value at current prices. It has the best governance we ever saw. If they continue to grow float, have underwriting profits and make good investments, it’s a steal. Never mind the recovery.

Q4 2009 report excerpts, part 2

“PERSPECTIVES”

Brazil

It is common for this section to be optimistic, where the managers explain why the future will be better, or at least like the past. Unfortunately, at least with regard to our expectations for our Funds’ returns, this is not the case. Results like those in 2009 are infrequent. The chances of seeing two years in a row similar to this one are very low.

In 2009 there was a fall in interest rates, the Real appreciated, and the country was in vogue, which – at least for us – was unprecedented. There is nothing to stop these factors from continuing (for one thing, because there is a certain correlation among them) and it would not even be extraordinary. But there are two problems that keep us awake. They are related to each other:

1. There is an almost unanimous feeling, internally and externally, that “now we’re off, this time it’s different”. This feeling is supported by the supposed validation of the thesis that “the global pneumonia is nothing more than simple flu” around here.
2. The big problem, of course, (and a direct consequence of the above-mentioned point) is the price base.

There is a great resemblance between the stock market at the end of 2008 and 2009: the sensation of inevitability of a trend and an almost unanimous opinion. These climates have proved mistaken in most cases.

We remember very well when IP was in its infancy, in 1989, and the Nahas case closed the stock exchanges in Brazil. We remember when President Collor froze bank accounts and investments in 1990, the Mexican crisis in 1994, the Asian crisis in 1997, the Russian one in 1998 and the Brazilian one in 1999 (the unforgettable “endogenous diagonal band” in the exchange rate). In all these cases, “this time it was different” and still “the house fell down”. Of these, the only one that seems to us to have had long-term effects was President Collor’s plan, which in fact has undermined the country’s credibility among many to this day.

Without fear of being repetitive, it is the changes in expectations that determine market fluctuations. Today, most people see the glass half full (or fuller). But there are more than enough reasons for a different view. Our growth has been supported by deficits in the balance of payments and in the fiscal balance, not based on savings or a measurable increase in productivity. The system remains jammed and very corrupt (for obvious reasons, it is impossible to state whether more or less).

No less important, in 2010 we will have presidential elections. Up to now, the economy and investors have allowed themselves the luxury of ignoring the relevant macroeconomic problems and the political risks. We have never seen a pre-election period involving a change of president with so much tranquility in the Brazilian capital market. Is it possible that everything has really changed, and that the political issue, so discredited and surreal, has embarked once and for all into a parallel universe? It would be marvelous, but in the end, “they” are the ones who define the rules, raise taxes, hamper the day-to-day routine. Like the androids of the film series “Terminator”, at each new film, precisely when the villain seems to be more harmless, he is much more dangerous. We have nothing to add to everything that is in the papers every day.  Except to stress and remind our readers that unfortunately political decisions do have an impact on the economy.

In line with this view, we closed the year with a high cash percentage. If the market continues to climb, we will still capture at least part of this rise. But the ideal scenario would be a crisis of expectations that would take prices back to levels where implied expectations were much worse than the present ones.  As a result, we could “put the turnstile back to zero”. As we have mentioned several times in the past, volatility is not a risk measurement. It is our great friend.

And what if we are wrong? We are running the risk of earning less than if we were more exposed. In fact, that is what happened this year. (…) Market timing is something we do not know how to do and do not intend to do. In the course of time, all those we have seen trying to do fine timing on a large scale, based on market “feeling”, have ended up being faced with the reality that, in the long term, this is a losing proposition. We do our timing as a consequence. We buy more when prices are low in relation to an expected reasonable value for the assets, based on well founded assumptions. We sell as the opposite starts to occur. Above all, before any other consideration, IP’s history of over 20 years has taught us that, to arrive in first place, first you have to arrive.

Global perspectives

We believe that the drastic changes at the global level have not yet ended. We continue to hold our view that current prices, in general, imply a more optimistic expectation than what experience and analysis of the interests involved recommend as prudent to follow. In fact, we see the governments of several countries (the USA in the lead) as great Madoffs, operating a great make-believe scheme. The story here is that future tax revenues will be sufficient to pay interest and all the “social” commitments. As in the Madoff case, it is much more convenient and pleasant to believe. But the truth is that the account hardly ever balances out. As in that case, the tendency is for there to be a disastrous ending for those who do believe (pensioners, long-term US Government security holders, etc.).

It is here that greater flexibility is most significant. (…) We do not propose to look at everything. On the contrary, we can reject everything that is less than optimal and concentrate on what we consider very good. At a time when it is even more difficult to find sound assets, with businesses carrying sustainable competitive advantages reflected in high returns on equity, managed competently and capably, at attractive prices, and when everything – even the traditional refuge in the dollar and in treasury paper – is questionable, this is a great advantage.

Our favorite cases continue to be independent of conventional classifications, such as by sector, geography or company size. However, certain sectors and certain geographical areas do have their biases, making them more attractive in certain situations.

In the course of the last few years, we have been trying to learn a little more about the health sector in the USA. Besides being the largest sector in the US economy, its complexity, segmentation and stratification make it the largest entrepreneurial laboratory we know of. The quantity of business models is virtually endless, given that in addition to vast diversity, the dynamism induced by the competitive, regulatory and technological aspects makes sure that there are always new models. At the very least, we have a wonderful tool gain, given that in many cases the models, or parts of them, end up being adopted by other sectors and/or in other geographical areas, giving advantages to those who have already studied and understood them.

Despite all the turbulence in the sector (in fact, thanks to it) generated by the Obama administration’s reform plans for the sector, this year we were able to reap some rewards from our effort, as in the cases of IMS Health (a position that we have already closed) (…); but we believe that there is still a lot of “juice” to be extracted from this fruit. The studies continue and it seems to us that, as in most cases, the media noise is helping to push down the prices of some assets more than could be considered normal.

Another sector that is still rather depressed (deservedly) in terms of asset prices, in the most developed markets, is the real-estate sector. It is difficult to know when growth will pick up, but it is certain that this will happen. Meanwhile, we continue to study the players, getting to know people and to understand the models and the “little tricks” of each sector/company.

Natural candidates are the businesses based on the pro-active and differentiated use of information. From our point of view, there are several attractions. Returns tend to be high due to the low levels of capital needed. The practical difficulty of implementation has historically been extremely high. Many companies have a vast pool of potentially valuable data, but the cases of those that manage to turn them into the great value creator they may represent are very rare. Those that set themselves up this way have a fantastic business, whose focus is the intelligent processing of information and which is “disguised” in companies classified in the most varied sectors, such as IMS Health (health sector), Amazon (retail), Google (media), Harrah’s (casinos), Co-Star (real estate), and Verisk (insurance), among others. In our traditional retail sector – an obvious candidate – despite our efforts we have found very few cases.

In short, we continue seeking companies with sustainable competitive advantages from a long-term perspective, which are able to generate value even in scenarios that are adverse for most, including those where changes in relevant paradigms occur. At the same time, we try to be on the alert for possible significant market distortions, caused by time imbalances or the application of models based on the adoption of assumptions that seem inappropriate to us.

It was also in this report that we first mentioned Buysiders.com to our clients, and we hope you all enjoy it.

In the “part 1″ we will highlight excerpts from the “Introduction” section of the report. Look for “part 2″ by Monday.

Q4 2009 report excerpts, part 1

“INTRODUCTION”

After a weak 2007 and a very bad 2008, we were pleased with 2009. Although the adjectives are in line with market behavior, as Neil Young says in one of his best-known songs, “Hey, hey, my, my (rock n’ roll can never die)“, “there’s more to the picture than meets the eye“. The restructuring of the research and management team – carried out in 2H 2008 – and, consequently, of the portfolios has been consolidated. The improvement in results, both from the quantitative and, more importantly, the qualitative point of view (addressed in the Q4 2008 report) has continued.

(…) In 2009 we had a good absolute and relative result, in a positive year for the market, when we usually have a good absolute performance but a bad relative performance. Above all, though we are very cautious and concerned regarding the market, we are very sure that we are doing the right things. As we stressed in the Q1 2008 report, we have no control over short-term returns, but we can and should control the investment analysis and management processes. Over time, the processes define the results. If we’re not yet where we would like to be in this sphere (the pot of gold is always at the end of the rainbow…), we have at least the conviction that we are evolving in the right direction.

Merge!

(…) a recurring event has been the participation of companies in our funds’ portfolios in large M&A transactions. Recently, Saraiva has acquired Siciliano, Itaúsa has acquired Unibanco (not to mention the Satipel and Porto Seguro deals), Odontoprev has merged with Bradesco Dental, and Totvs has acquired Datasul. At the other end, Globex was sold to the Pão de Açúcar Group. In the international front, InBev has acquired Anheuser Busch (Budweiser) and Berkshire is acquiring Burlington.

Two factors make this observation worthy of greater consideration.

In the first place, we have the historical observation that transactions of a “transformational” nature are risky.

If we take a broad universe of companies, there are many bad results. Daimler/Chrysler and Time-Warner/AOL are cases that spring to mind immediately as perfect examples of what may not work. On the other hand, the overall record of what Itaú and AB-InBev are today shows that we should not reject all operations of this nature a priori.

A positive indicator that seems to us to keep a good correlation with the transaction’s result is when the party that takes the initiative does so from a strong position, with a positive growth agenda. In these cases, it makes a difference to be at the right end. Even though there is usually a “premium” in relation to the acquired company’s recent stock prices, it rarely compensates the long-term investors who have “held the ice cubes in their hands”. It becomes a matter of timing, and it is not by chance that this is the category in which traces and evidence of insider trading are most commonly found.

In the opposite situation, “shotgun weddings”, where two weak parties that are under threat join together, usually lead to worse results.

Another potentially negative case is when large “depersonalized” corporations with weak governance end up being oriented, in practice, by their bankers and advisers. In such cases, what we end up seeing is an apparently unending series of senseless transactions with no effective “buy-in” by executives, generating progressive value destruction.

Another point is that in the great majority of banks’ and brokers’ reports that we see, and that are possibly the main drivers for price formation in the short term, the detailed models rarely incorporate the possibility of value destruction. The argument is that it is obviously an issue that “cannot be modeled properly”. But as we never tire of repeating, “unquantifiable” may be completely different from “irrelevant”.

How can one quantify a good management that knows how to select good alternatives and abandon those that are attractive but whose price cannot be justified (as in the case of Renner/Leader), and then efficiently manages the always difficult integrations? Our answer is that each case is different from the next one. We do (very simple) simulation exercises in order to have a range of potential values, and we invest most of our time in getting to know and understand the logic and the real incentives that motivate the managers, and the competitive market conditions within which the companies participating in the transactions operate; how the idea for the transaction arose and evolved, who their advisers are, and other qualitative factors. It is better to be approximately right than precisely wrong.

Dividends vesus Bonds

An interesting issue for those who believe in efficient markets was the situation between shares and bonds issued by high-quality global companies observed during a good part of 2009. Joseph Stiglitz, a Nobel Economics laureate, in his address to the annual meeting of the American Economic Association at the end of December 2009, fired a heavy attack at his colleagues who create models that depend on the assumption of rational behavior, when the real world insists on not fitting into this mold. During the 2H of 2009, many investors tried out their return to the markets (as they received redemptions from hedge funds or got tired of returns close to zero yielded by US Treasury securities), buying bonds.

At the height of the crisis, there were moments when fixed-income securities issued by some low-quality companies were traded at prices that seemed very low to us, but as the year advanced, that was no longer the case in most of the market.

When doing our calculations in the second semester, we could not understand the market’s logic. In several cases, the dividend yields on stocks were very close to the yields on bonds (obviously taking care to include only companies with the capacity to continue paying dividends in the future). Usually, dividends are relatively lower for the following reasons:

1. Bonds and stocks have 100% downside.
2. Bonds usually pay coupons and redemption of the principal in a given currency, fixed beforehand. On the other hand, the revenues and results of companies are generated worldwide, and the respective dividends are defined a posteriori. As there is usually a “desired” inflation rate in the systems, the current yield on the stocks of sound, growing companies should be lower, in terms of present value. In the present case, for those concerned about an acceleration in US inflation in the course of the next few years (as we are), at similar current yields, stocks of companies with quality businesses are relatively even more attractive. Obviously, the opposite reasoning applies to the hypothesis of deflation.
3. These companies pay out less than 100% of the profits for each financial year in dividends. The remainder is reinvested in order to generate increasing profits and dividends (while bond coupons are fixed).

In fact, shares of companies like Coca-Cola, Nestlé and Procter & Gamble appreciated well, and part of what seemed a distortion to us was corrected. But only part. Our philosophy cannot be reconciled with long-term fixed-income securities that carry fixed yields in dollars at the present levels, nor with stocks of high-risk companies at prices that imply optimistic scenarios that are not based on our vision of the world. We prefer to have cash or stocks of companies that are capable of generating cash, even in the most adverse scenarios, and that are trading at reasonable prices. Our experience is that even if there is zero return for some time, when opportunities finally appear, the returns more than compensate for the wait.

IMS HEALTH

IMS is another global business (nearly two thirds of its revenue come from outside of the U.S.) focused on information and intelligence on the health market, mostly the pharmaceutical industry. Its main products are information on prescription, sales and the market share of medical drugs, which can be sorted by micro- geography, medical specialty, distribution channels and other criteria. Its main customers are pharmaceutical laboratories worldwide such as Pfizer (the largest customer accounting for approximately 5% of revenues) and biotechnology startups. It is the leader in this global business and sells more than USD2 billion per year.

The nature of this business brings many desirable features:

– It requires little capex. The company has less than USD200 million in physical assets (net of depreciation).

– Very high barriers to entry. Gathering detailed information globally is a tough task. The way this information is organized, the statistical treatment and the training for its interpretation and use, and the trust conquered during 50 years make a big difference.

In addition, the company features positive financial data:

– During the past eight years the company repurchased its shares aggressively, reducing the outstanding figure from 300 million to 180 million. The average price of these acquisitions was nearly USD18 – already adjusted to possible dilutions. Considering that the trading price in the period stood between USD15 and just over USD30, the acquisitions were made at a good price. The practical effect is that those who held their shares increased their participation in future earnings at good prices. (On September 30 the price was USD15.35).

– In general, between 2001 and 2008 the company:

— Generated USD2.8 billion of cash from operations

— Invested USD1.5 billion in its own business (investments + acquisitions + software), managing a USD1.2 billion increase in revenue (productivity of approximately 75% in a business that has on average 15% to 20% cash margin).

— Paid nearly USD2.3 billion to shareholders, of which USD2.1 billion was paid through repurchases (net of issuances) and USD170 million in dividends.

— The difference was “settled” in a debt increase amounting to approximately USD1 billion. It is important to note that this is a long-term financing at a low cost and with comfortable guarantees, which is payable with the company’s cash generation.

— The Enterprise Value (shares’ market value + net debt) was USD8 billion in 2001. Today it is USD3.5 billion. Meanwhile, earnings and cash generation more than doubled from USD130 million to USD310 million, and from USD190 million to USD450 million, respectively.

Obviously, such data leads us to think that something could be wrong. What is the “counter-case”?

We have been investigating this closely, contacting the company in the U.S., its offices in Brazil and their clients. We have also hired consultants that specialize in the sector. We identified four main points:

First, the turmoil in the health sector, particularly in the U.S. That is a fact, but the impact is not negative and perennial on all the participants. Given the projected changes for the sector, it is valid to think that information is highly valued in turbulent markets.

On one hand, the big pharmas are the largest clients (and these will lose their billion-dollar contribution of many blockbuster drugs in the next 3 years), on the other IMS has thousands of them, with annual revenue per client averaging more than USD500 thousand. Its clients include most producers of generic drugs and many promising specialty manufacturers in areas such as oncology, in addition to many regional companies (small and medium-sized) in emerging economies that have grown faster than the giants in more mature markets.

There is an interesting point, balancing the lack of visibility in the U.S. health policy. The company’s largest shareholder is Ariel Investments, with a stake amounting to approximately 7% according to the most recent available information. An article published in the Wall Street Journal shortly after Obama’s election is worth remembering: “Tuesday’s election transformed John Rogers from an obscure money manager who eats at McDonald’s every day into a confidant of the world’s most-powerful man, come January. Mr. Rogers is chairman of Chicago-based Ariel Investments, the largest African-American-owned investment firm in the country… Mr. Obama spent Wednesday – his first day as president-elect – at Ariel’s downtown Chicago office, huddling for six hours making calls and planning.” Ariel’s stake in IMS is the sixth largest in its fund, and it keeps growing while the five largest decrease.

Second, we identified that the company is trying to accelerate growth by creating more customized, higher value-added services, in line with the track record of the top management, who came mostly from IBM. However, the success of this initiative has been small, so far. The company hasn’t yet netted large, strategic contracts, in line with “helping companies use the precious data it supplies to jointly develop global market strategies”. But given current prices and implicit multiples, not only are investors not paying for the project but there is also a discount due to the risk of value destruction.

We are still unconvinced about this issue. Today this is where we allocate most of the margin of safety, which we believe that exists in the shares’ price.

Third, we have the omnipresent technology risk. Theoretically, the dissemination of online systems could be a threat. And they certainly are. E- prescription programs, where doctors prescribe through systems that are integrated with pharmacies, can facilitate competition. However, “facilitate” may sound like an euphemism. In fact, it would make possible something that was previously deemed impossible. But we have serious doubts whether it is feasible. Also, obtaining the data is just part of the story. Having the clients and getting them used to the products and standards is different. The more ambitious IT programs in the health sector have so far failed in terms of results (in general that is a great business for suppliers). We will get there one day, but we have lower expectations than the market in general. Barriers are not only technological. They have to do with semantics, standards, and processes. In the end, they are linked to interests, incentives and cultures. And as we know, that is much more difficult to change.

Ultimately, an annoying, albeit not eliminatory aspect is the low level of insider ownership. The company doesn’t have a clear owner, although some of its main executives have a relevant part of their net worth committed to IMS. This has an obvious impact on business and it would not be reasonable to expect from the company a level of commitment and focus as seen at AB InBev, for example. On the other hand, this has been the case for years. And while some benefits of a more incentives-prone structure are lost, we do not find evidence of this being something harmful, as seen in many other cases. Conversely, the considerable repurchase of shares throughout the years is nothing short of surprising under these conditions. Once again, the size of the position in Ariel Investments is an upside. Even if it does not act proactively as a controller, it certainly soothes risks linked to a potential agent conflict on the part of the executives.

(…) In addition to all the issues above, the market may be exaggerating the uncertainties in the U.S. market because the company is headquartered there, although this business is global. (…).

LINKS

The official press release

With IMS Deal, Healthcare is Back on Top – WSJ’s Private Equity Beat blog

How do You Get Out of IMS Health – Barron’s (on what could be TPG’s exit strategy – independence is a very important feature of IMS’s business model, so pharma cies. are out of the picture. But who said TPG won’t try to go public with IMS in a few years?)

Q4 2008 report excerpts on moral diligence: Part 2 of 2

“ON MORAL DILIGENCE”

“What aren’t you able to bring men to do, miserable hunger for gold!”

Seneca

2008 was a long, hard and troubled year, during which the world financial system had its governance and compliance structures questioned, and the markets went completely off the rails; they were severely destabilized and shaken by a crisis of confidence that was unprecedented in complexity and scale.

It is no exaggeration to say that, from September on, the generalized uncertainty and mistrust severely dried up the liquidity of a system that had already been staggering for over a year, locking its financial and transactional gears.

The banks, whose very existence is founded on the most basic form of “credit”, their reputation, stopped believing in each other’s balance sheets and capacity to survive. They discredited their own auditors, as well as their compliance mechanisms and risk gauging and control systems. They started to doubt the payment capacity of those they finance. Insurers stopped trusting those they insure, and vice-versa.

All over the world today, producers suspect suppliers, and salesmen their customers. Contracts were and are being questioned, suspended and canceled. Voters are skeptical about the capacity of their governments to resuscitate the markets and the economy in a fair and efficient manner. And governments do not believe in the autonomy of the markets. The market, in turn, trusts neither the government nor the regulators. Investors question their advisors, who in turn question their managers, who no longer believe their economists and analysts, who do not trust their models any more. It is a long list. Bonds of trust, once broken, take time to rebuild. And many of the consequences and effects of these ruptures are yet to come.

In this context of worldwide broken trust, we would like to share with our clients, business partners and friends a reflection of a moral nature. But one that is not moralistic.

In our opinion, which differs from the consensus, to reduce the recent events to human “greed”, to deposit them in the account of the “irresponsible behavior of a few” or, at the opposite end, to interpret them as a direct, exclusive and inexorable consequence of a framework of incentive systems and the conflicts of interest associated with same – for which, at the end of the day, no-one feels responsible or accountable – is to ignore an issue that we consider crucial: it seems to us more interesting to look at the situation from a “micro” point of view, where we can in fact take action, than from a “macro” angle, where searching for culprits and definitive explanations, or even postulating solutions, is beyond our scope and competence.

In the sky-high “macro” sphere, realm of Them, the Others, we all think ourselves creditors and victims. But it is in the streets and alleys of the “micro” sphere that We are (or should be) accountable.

It seems more productive to use the crisis as a backdrop for us to reflect on potential forms of protection against our own recurrent fallibility (greed, imprudence) and the fluctuations in the alignments of interest that are intrinsic to each and every relationship.

We could hastily reach the conclusion that the design of the incentive systems that govern the relationship of agents in markets and organizations “perverts character”, instigating agents to “act”. And conclude, like Shakespeare’s Cassius trying to persuade Brutus to murder Caesar: “For who so firm that cannot be seduced?”

And how can we apply this premise on a “macro” scale? Re-designing the explicit and tacit incentive systems that govern exchanges among the agents? Establishing more and better surveillance, reinforcing regulations, imposing more controls? Frankly, we haven’t the faintest idea. It is outside our circle of competence and, honestly, we are somewhat skeptical about it.

But with regard to our own “circle of trust”, emphasizing the importance of all of us acting in a morally diligent fashion – especially in selecting our business partners, employees and investments – is definitely in the order of the day. And there is no doubt: this is an extremely important subject that generally goes unnoticed while the world moves full steam ahead, and only becomes evident and haunts us at times of crisis.

We wonder whether to ponder such a question is the quintessence of naiveness on our part. But naive and foolish is to think that only the “market’s” incentive systems are misaligned or corrupted.

Yes, in the financial sphere, there are very clear points of unbalance, which, as became evident in this and in several of the latest crises, instigate behavior that crosses, without shame or remorse, the frontier between simple “misalignment” and moral issues. As we have seen, the huge machine of transactional efficiency of the global markets intensifies this effect.

But it is worth looking at this issue very closely: to well- trained eyes, conflicts of interest are easy to see. In many cases, like the Wall Street bonuses, they are explicit.

But “misalignments” – that is, the imperfect convergence of interests among agents – are much more difficult to see. Primarily, they belong to the sphere of the tacit. They are multi-dimensional and fluctuate over time. They are much more difficult to pick out in contracts or schemes. Preferences change over time. They are volatile, ambiguous and conflicting. Anyone who has had friends or partners knows exactly what we are talking about. By definition, there is no “perfect” alignment of interests. Or do you think that this malady is exclusive to the financial market?

Yes, structurally, we live under the aegis of a generalized misalignment of incentives – from our government systems to mechanisms for remuneration and promotions in companies, which, given time, could even be corrected, improved, or at least better watched over, controlled, punished.

But the other side of the coin, what demands our attention a great deal is that, despite the “structures”, “systems”, “markets”, the social pressure to follow tacit rules and behavioral consensuses, the struggle to deliver significant results, to be better than the competitors, there is ALWAYS the option, as a matter of principle and discipline, to use from the very beginning a high moral filter for everything we do.

The option to say “I will not take part in this”, “No, I will not invest in this fund with the best Sharpe Ratio without fully understanding the process that generates this irreproachable performance”, “No, I will not manage this company or investment fund aiming at short-term results”, or “I will not do business with these people of questionable reputation” DOES EXIST. Always.

This posture is valid with regard to managing our own business – as usual, it is always easier said than done – but it also extends to the people close to us, and is especially critical with respect to the business partners we select – in relation to whom our degree of control is clearly lower.

It is not by chance that, as long-term investors, one of the aspects that we most consider in filtering our potential investments are the people involved and their motivations. What type of partner do we want? Has the company in fact an owner or owners? Who are they? Where do they come from? What are their aims, their ambitions for themselves, for their families and for the company? What do they value and despise? How are they called to account? How do they measure their progress, their success? How do they act in relation to their associates (business partners, clients, suppliers, etc.)? What are the values that are really adopted and practiced by the company: how are they reflected in the behavior of the owners and employees? How do the explicit and tacit incentive systems of the different areas of the company interact among themselves?

Fully understanding how the organization chart of a potential investment really works in real life (in greater or lesser harmony with the company’s explicit incentives) should be covered in a special chapter in each and every book on valuation.

It is astonishing how powerful an analysis based on people and their motivations can be. What is more, this “social auditing” should also be extended to the company’s “neighbors”, the key points in its value chain.

For example, when we “analyze” a company that sells products and services to another, it is crucial also to know: WHO is really responsible for the purchase of the company’s product? How is HE compensated? How is HE, the buyer, profiting from the purchase? What is HE placing at stake?
In short, if the misalignment of interests among “agents” (always flesh-and-blood people) is a fact of life, there is only one reasonably effective way to deal with this: to make use of a high moral/reputational filter and to keep within our circle of trust just a few business partners/associates, but good ones: competent, ethical and genuinely aligned.

A good example of moral diligence to be followed is that of Warren Buffett, whose control and governance system for the companies in which he invests is, at first sight, rather “loose”. And even so, he gets it right much more often than not.

In the words of Charlie Munger, his partner at Berkshire Hathaway: “it’s wonderful to be trusted. Some think if we just had more compliance checks and process, virtue would be maximized. At Berkshire, we have subnormal process. We try to operate in a web of seamless trust – deserved trust – and try to be careful whom we let in.”

Part of their secret: a very good eye for evaluating a person’s character (and the ability to audit their reputation with a couple of phone calls). But obviously the two men only developed this sharp perception because, at a given moment in their careers, they gave this filter a disproportionally high weight in evaluating potential investments. This makes all the difference.

If on a scale from one to ten, traditional investors give a weighting of 3 or 4 to traits such as integrity, character and values, in Buffett’s case, where the horizon for carrying an investment is “forever”, there is no other way: the weighting must be close to 10, and in the hierarchy of desirable attributes of a good investment, precede all others.

Buffett applies a high moral filter, he says, always seeking three characteristics in his potential business partners: integrity, energy and intelligence. In this order. And in his own words: “if your candidate does not have the first, the other two will kill you”.

On the other hand, it is important to stress that, sometimes, basing a good part of the process of selecting business partners on an apparently robust moral filter, but without due diligence, has the opposite effect. In cases such as that of Madoff, the exaggerated trust that many of his victims placed in the investor’s most obvious traits (former Nasdaq chairman, a link with charity and the Jewish community, several of his investors had an irreproachable reputation, his intermediaries were renowned companies, the fund always delivered good, consistent results, though not extraordinary, and for years on end) created an aura of “integrity” around him that made his scheme very convincing for a long time. In this case, the “moral” trait took part in the selection process, but diligence was insufficient. The golden rule is “Trust. But verify”.

Well, taking all that into account, what should be done from the practical point of view to safeguard ourselves, at the “micro” level, from our own mistakes?

Firstly, having a very clear notion of our suggestibility and susceptibility (recurrent fallibilities and biases), and controlling it with principles, values, discipline, systems, internal processes, and a competent, aligned team; demanding a significant margin of safety; and knowing that, even though well-meaning and alert, we can be (and are) fooled by our senses, judgment and evaluations of information and – even more important – people.

Secondly, building an environment that will clearly promote incentives other than just material ones (starting with the selection of people using an ever higher “moral filter”), in harmony with the principles and values practiced in the company (selection of associates/counterparties – few, competent, honest and aligned – who share these principles).

Thirdly, being morally diligent – with ourselves and our business partners. This applies to the evaluation of the companies in which we invest, to the people we hire and keep in our team, to the people who render us services, to our business partners, and to our clients as well.

CONCLUSION

We used as a backdrop reflections on “incentive systems”, like those that marked the present financial crisis – and, along with several other factors, helped to gear it up – in order to throw a somewhat solitary light on another place: the importance of raising our standards, our moral filter, ever higher when making our choices, less as agents of a transactional system, but more as responsible members of a community.

When we reflect on last year, one of the most important things we have learned is that there is no better risk control than to be surrounded by good business partners and few, both in-house and outside: competent, well educated, ethical, and genuinely aligned with and committed to us for the long term.

In this respect, we seek always to be on the alert – and even so, now and then we err in evaluations and judgments.

To elect a high moral filter as a crucial instrument for risk control has a high “visible cost”. The universe of investments that we can consider is drastically reduced (it is not for nothing that we seek to invest in companies on a global scale, so as to expand our reach without having to lower our governance and management-quality benchmark). The universe of employees that can be hired and eligible partners, ditto. In short, as a rule, our number of potential business partners falls a lot.

On the other hand, the “invisible benefits” generated by this more conservative conduct are extremely valuable to us. And in our assessment, they more than compensate the visible costs.

A good way to think about moral diligence is to make use of an old friend: the margin of safety concept. Just as we must invest in companies whose price offers a significant margin of safety in relation to our perception of their value, we must also require a “margin of safety” when we assess the moral contours of an opportunity for an investment or partnership.

The fact that we seek to be always on the alert does not mean that we always get it right, whether internally or externally. Last year is a good example of that.

But the simple fact that we pay attention to the importance of being increasingly morally diligent with ourselves and with our associates helped us to minimize some of the mistakes made and to correct them relatively quickly. Our portfolio today is, to a large degree, a positive result of these changes.

(…)

As a final message, a very simple observation: properly exercising what we call moral diligence implies doing more with less. The universe of investments, counter- parties and partners that can be considered is reduced. And that is precisely the direction we’re following. We want few but good business partners with whom we can cultivate and nourish relationships that transcend the transactional.

To have a select group of clients and business partners who admire and trust you is immeasurably more valuable than an infinite number of clients and business partners that maintain a merely transactional relationship with your company. In this respect, we feel privileged.

We agree once more with Buffett and Munger: “we try to operate in a transparent web of seamless trust – deserved trust – and try to be careful whom we let in.”